Economic Commentary
Daniel Laufenberg, Ph.D.

Numerous economic data series are released between the publication dates of the Laufenberg Economic Quarterly (LEQ). These commentaries are designed to provide insight on the more recent data and their implications for the economic outlook.

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Is the dollar's status as the reserve currency at risk?
(March 21, 2011)

Some commentators have expressed concern that the U.S. dollar’s status as the world’s reserve currency is at risk because of a prolonged period of very accommodative monetary policy and massive federal budget deficits. They contend that under such circumstances, the rest of the world will be inclined to reduce markedly their holdings of assets denominated in dollars, causing the foreign exchange value of the dollar to plunge. Such a flight away from dollars and dollar-denominated assets would cause asset prices to fall, inflation to climb, interest rates to skyrocket, and the cost of financing the growing federal debt to become untenable. Indeed, a few people argue that the situation will become so grave that the U.S. government will be forced to default on its debt.

Although anything is possible, I would assign a near zero probability to a default by the U.S. government. Indeed, global investors apparently agree with that assessment given the still very low interest rate on U.S. Treasury bonds. After all, if investors were concerned about the U.S. government defaulting, real Treasury bond yields would reflect that concern and be much higher than they are currently.

Another implication of relatively low Treasury bond yields is that investors have assigned a very low probability to the risk of a collapse in the foreign exchange value of the U.S. dollar anytime soon. Nevertheless, that does not preclude the dollar from continuing to decline on average over the next decade or more assuming no major surprises in fiscal and monetary policies during that time. Indeed, I expect the foreign exchange value of the dollar to decline, but in an orderly fashion. Moreover, the dollar’s decline will not be universal—the dollar is expected to remain stable to possibly appreciate a bit against the currencies of some developed economies, but depreciate against the currencies of developing economies. As such, the decline in the major currency index, which is a weighted average of the of the foreign exchange value of the U.S. dollar against a subset of currencies that circulate widely outside the country of issue, will be less pronounced than the other-important-trading-partners (OITP) currency index, which is a weighted average of the foreign exchange value of the U.S. dollar against a subset of currencies that do not circulate widely outside the country of issue (see Chart 1). An example of a major currency would be the euro, while an example of an OITP currency would be the Chinese yuan.

The major currency index, which is the dollar index that is included in the Laufenberg Quarterly forecast, trended higher from 1997 to 2002, turned downward on average from 2002 to 2008, and has been trending sideways ever since. Indeed, with the bounce in the dollar in late 2008, advisors were asking at the time about the outlook for the foreign exchange value of the dollar. My response was that it likely would be little changed on average over the following three years. As shown in Chart 2, the major currency trade-weighted dollar index has been flat on average over the last three years (as measured by the trendline for the major index). In other words, the foreign exchange value of the dollar, like most prices, responds to the business cycle. At the moment, the index is below its recent trend but probably not for long. Once the U.S. economic recovery accelerates, budget deficits subside, and monetary policy becomes less accommodative, the U.S. dollar will look relatively more attractive to foreign investors than other major currencies.

On the other hand, the trade-weighted value of the U.S. dollar against the currencies of OITP, as measured by the OITP index, climbed from 1997 to 2003, retreated as well from 2003 to 2008, jumped in late 2008 into mid-2009 and has slipped again ever since. Over the 1997 to 2011 period, the OITP index has trended higher on average. However, more recently (2009 to 2011), this index has moved downward on average. This dollar index also responds to business cycles.

But this begs the question of why I am so confident that the U.S. dollar does not lose its status as the world’s reserve currency anytime soon. First, there needs to be an obvious alternative to replace the dollar as the reserve currency. For now, there is none. The requirements for a reserve currency are very demanding. For example, the currency has to be issued by a country that respects individual property rights, and has both the legal system and the military power to enforce those rights. The U.S. is the only country that satisfies those requirements at the moment. Europe and Japan may respect property rights and have a strong legal system, but neither have the military power to enforce them. In fact, whenever they get into a situation that may require a military response, it is usually the U.S. that comes to their aid. Moreover, the political and economic systems in the U.S. seem a bit more stable than other developed economies, although those conditions are perceived by some to be less favorable to the dollar than they were. That does not mean that the U.S. economy is immune to business cycles, but rather that the U.S. economy’s potential growth rate is still higher than that of other developed economies. To the extent that changes—and it could someday—the U.S. dollar will no longer be the currency of choice.

Certainly, there is no developing economy now or in the foreseeable future that has or will have the necessary conditions to make its currency eligible to function as the world’s reserve currency. In particular, developing economies do not always respect property rights, making a mute point of whether they have the military power to defend such rights. Moreover, their political and economic systems tend to be more unstable than that of the U.S. or other developed countries.

Second, in order to determine what currency might be a reserve currency, it is important to note the functions of such a currency. A currency is defined as a reserve currency because it often does a better job of functioning as money than the holders’ local currency. Recall that money has several functions, including a unit of account, a medium of exchange, a standard of deferred payments, and a store of value. For example, why is China willing to hold dollar-denominated assets? I contend it is because the dollar does a better job of functioning as money, especially as a standard of deferred payments, than the Chinese yuan. This is because the yuan is not circulated outside of Chinese—it is not a convertible currency. As such, it needs another currency to serve that function. For China, the U.S. dollar functions as a unit of account; that is, not only are most globally traded commodities priced in U.S. dollars, the Chinese have effectively pegged the yuan to the U.S. dollar. Also, the U.S. dollar serves as a medium exchange in global markets for China since its currency is not allowed to circulate outside of China. And to a large extent, the U.S. dollar serves as a store of value, since it still is considered a safe haven for global investors. In fact, one could argue that the confidence in the yuan as a local currency is supported in large part by the U.S. dollar reserves held by the Chinese government.

A note of caution is warranted at this point. In particular, arguing that the U.S. dollar will remain the reserve currency for a long time is not synonymous with arguing that the dollar will appreciate in the long run. At the moment, there is no other currency that functions like money in global markets better than the U.S. dollar. That being said, the foreign exchange value of the dollar is likely to trend lower over the next several decades, but mostly against currencies of developing economies. Indeed, I expect the dollar to appreciate slightly against the euro and the yen in the foreseeable future but it will be offset by declines in the dollar against the currencies of the faster growing emerging economies, such as China, India, Brazil and maybe even Russia. Nevertheless, I would not bet that this decline in the U.S. dollar relative to the currencies of emerging economies will persist forever.

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Dlaufenberg@stonebridgecap.com

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.


2011 Com2011 Commentary

Living in interesting times
-- September 8, 2011

A not so pleasant surprise!
-- September 2, 2011

Surprise!
-- August 16, 2011

Debt ceiling politics
-- July 25, 2011

Q2 growth: Another disappointment likely
-- July 14, 2011

Interpreting the ISM manufacturing index and the employment situation report for May
-- June 4, 2011

A slower start to 2011 than anticipated earlier
-- April 14, 2011

Is the dollar's status as the reserve currency at risk?
-- March 21, 2011

More trouble in the Middle East
-- February 26, 2011

Searching for the next debt crisis
-- January 13, 2011

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